Traditional IRA Beneficiaries & Taxes
Inherited Individual Retirement Accounts maintain the same tax-advantaged status they did when the original owner of the account was alive, but other features regarding inherited accounts differ. Further differences exist depending on whether the beneficiary of the account is a spouse, as spouses who inherit IRAs are afforded special privileges that non-spousal beneficiaries are not. Regardless of the beneficiary, at some point distributions will be mandatory, and those withdrawals will be taxable.
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Traditional IRA Characteristics
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A traditional IRA is a tax-advantaged retirement savings account. Contributions and earnings in an IRA are allowed to grow tax-deferred until withdrawal, when they are generally taxable. An IRA account owner is allowed to designate beneficiaries who will inherit the account when they die. In community property states, if the beneficiary is not the spouse, then the spouse must sign a form relinquishing any claim to the IRA upon the owner's death.
Spouse as IRA Beneficiary
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If a spouse inherits an IRA account, he is allowed to take ownership of the account as if it is his own. In other words, after the transfer, the account is retitled in the name of the spouse, and the IRA continues as if the spouse had always owned the account. Thus, the spouse may contribute to or withdraw from the account, name his own beneficiaries or rollover the IRA as he wishes, subject to IRS regulations. Distributions are not required to be made until the spouse beneficiary reaches the age of 70 1/2, just as if it was his own IRA. There are no tax ramifications to a spouse inheriting an IRA.
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Other IRA Beneficiaries
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Non-spousal beneficiaries are not permitted to treat an inherited IRA as their own. Thus, non-spousal beneficiaries cannot rollover inherited IRAs, nor can they contribute to them. Additionally, inherited IRAs cannot be retitled in the name of the beneficiary; rather, they must be titled in the name of the decedent for the benefit of the beneficiary. Non-spousal beneficiaries also have different distribution rules from spousal beneficiaries. If the owner of the account died on or after they began taking their required minimum distributions, then a non-spouse beneficiary must begin taking distributions from the account based on his single life expectancy, as shown in IRA Table 1, or on the owner's life expectancy based on his age at death. If the owner died before beginning RMDs, then distributions for the non-spouse beneficiary are based on the beneficiary's life expectancy.
Taxation of Distributions
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While no income tax is due when any beneficiary inherits an IRA, the remaining taxable provisions of IRAs remain the same. Generally speaking, when any distribution is taken from the IRA, even for a required distribution, the withdrawal is taxable at ordinary income tax rates.
Penalty Taxes
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Normally, distributions taken from an IRA before the account holder reaches age 59 1/2 are subject to a 10 percent IRS penalty for early withdrawals. This hold true for spousal beneficiaries that are under the age of 59 1/2 as well. However, for non-spousal inherited IRAs, distributions are not subject to this penalty tax.
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